FinTut is a computer-based tutorial that students can work through at their own pace. It is used to develop and reinforce a better understanding of financial

FinTut is a computer-based tutorial that students can work through at their own pace. It is used to develop

and reinforce a better understanding of financial

statements, their interpretation, and analysis.

FinTut features 3 sections:

The components of financial statements, the information each conveys, and definitions.

Ratios and performance measures, and how they are calculated.

A benchmarking exercise based on GizmoWorks financials and the Auto Parts industry.

Max Does Financial Analysis

In addition to traditional accounting activities, I am very

involved in providing consulting services to

my clients.

I always start with a thorough financial check up. It still

amazes me how much I can learn about a client’s strengths,

and opportunities for improvement by

conducting a thorough financial

analysis.

Spend a few moments with me as I conduct an analysis of a new

client, The GizmoWorks

Company. They manufacture and sell aftermarket parts to

auto enthusiasts.

The insight I am about to gain will

benefit me immensely as I work with them on strategic issues.

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Analysis

Finance 101

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Summary

Finance 101Financial Statements summarize a firm’s position and performance. The two principal statements are the Balance Sheet and the Income Statement.

Accountants prepare these statements on a periodic basis (monthly or quarterly) using consistent standards that are accepted by the profession. Generally, the balance sheet is oriented toward the present and future, and the Income Statement is a reflection of past activities.

Balance Sheet

A Balance Sheet summarizes what a firm has to work with (assets), and how these assets were financed (borrowed or contributed by the owners). A balance sheet provides insight into asset efficiency, risks, and how the firm is positioned for the future.

Key Definition:

Balance Sheet - A financial statement that summarizes a firm’s assets, liabilities, and owner’s equity at a given point in time.

Balance Sheet Structure

Assets - Things of value a firm owns. Assets are grouped in 3 ways: Current assets, long-term or fixed assets, and intangible assets. Assets are valued on the basis of historical cost or market value – whichever is lower

Current Assets - The assets of a company that are expected to be realized in cash, sold, or consumed during a one-year period. The bulk of current assets will be comprised of cash, accounts receivable, and inventories, and are described as the firm’s working capital.

Cash - Coin and currency held by a firm plus checking account balances. Some short-term highly liquid investments such as Treasury Bills are considered to be cash equivalents.

Accounts Receivable - Dollars owed to a firm by customers as a result of credit sales. Accounts Receivable are valued on the basis of net realizable value – the amount that likely will be collected.

Inventory - Goods held for resale by a retailer or distributor. A manufacturer will list raw materials, the value of work in process, plus finished goods. Inventory is valued at historical cost, or market value – whichever is lower.

Fixed Assets - Assets that are not consumed during a one-year period, are valuable in the production, sale and distribution of products and services, and are needed for the operation of the firm. Most fixed assets will be categorized as property, plant, and equipment.

Intangible Assets - Assets with no physical attributes, but are valuable because of advantages or rights they give a business. Examples include patents, copyrights, trademarks, high customer loyalty, or a superior workforce (the latter 2 are considered goodwill). Intangible Assets are valued at cost and must be evidenced by an arm’s length market transaction.

Current Liabilities - Short-term (less than 1 year) debts or payments a firm is obligated to pay. The bulk or current assets are likely to include accounts payable (generally dollars owed suppliers), notes payable, taxes owed, and wages payable.

Long-term Liabilities - Debts that the principal amounts need to be paid back over periods greater than 1 year. Long-term liabilities are valued at present value and not the sum of future payments. Long-term debt is generally incurred as initial capitalization of the firm or to finance growth opportunities.

Equity - The owner’s stake in the business. Owner’s equity is comprised of their direct investment in the business (capital stock), plus undistributed profits (retained earnings).

Balance Sheet Structure

Income StatementAn Income Statement (sometimes referred to as a profit and loss (P&L)statement) summarizes the profitability of a firm’s activities over a stated time period. It is also useful in evaluating growth, operating efficiencies, and value creation. Income and Profit mean the same thing.

Key DefinitionIncome Statement - A financial statement that reports revenues and expenses and shows the profitability of a business for a stated time period.

Revenue Inflow of assets (usually

cash or accounts receivable) generated by the sale of goods and services (note: not the sale of fixed assets). Revenue is recognized on the financial statements at the time ownership of the goods is transferred (usually when shipped) or when the service is rendered. “Net sales”, or just “Sales” is often substituted on the income statement for revenue. They mean the same thing.

Cost of Goods Sold (COGS)

The price paid by the distributor for the product being sold or the cost to manufacture goods that are sold during an accounting period. COGS for a manufacturer is the direct labor, materials, and manufacturing overhead.

Formula:

COGS = Beginning Inventory + Cost of Goods Manufactured (or purchases) – Ending Inventory

Gross Profit Dollars

The difference between revenues and the cost of goods sold over a stated time period. When stated as a percentage, this measure is considered the gross profit margin.

Formula:

Gross Profit = Revenue - COGS

Operating Expenses

Expenses other than cost of goods sold incurred in the operation of the business. Included are sales expenses (including marketing costs), general expenses (rents, insurance payments, office supplies), and administrative expenses (salaries for executives, accountants, office support, etc). Sometimes these expenses are classified as sales, general and administrative expenses (S,G & A).

Operating Profit

An important measures of profitability that reflects the profit derived from the normal functions of running a business. It is the remaining revenue after cost of goods sold and the cost of operations (sales, general and administrative costs) are accounted for. When stated as a percentage this measure is referred to as the operating margin. Operating income and operating profit are the same thing.

Formula:

Operating Profit (or Income) =

Revenue - COGS - Operating Expenses

Interest Expense

The charges incurred during the income statement period on interest bearing loans and notes. These costs are considered and reported separately from normal operating expenses.

Tax Expense

The total federal, state, and local income taxes owed on the business profits.

Net Income

The remaining profit after all expenses (cost of goods sold, operating expenses, interest, special charges, and taxes) are subtracted. Net Income and Profit are the same thing. When net income is expressed as a percentage of revenue it is known as net profit margin or return on sales.

Formula:

Net Income (or Profit) =

Rev - COGS - Op Exp - Int Exp - Tax Exp

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Analysis

Finance 101


Summary

Financial Analysis

Using performance measures derived from the financial statements, and comparing these measures for GizmoWorks to standards in the Auto Parts industry in which they compete, it is possible to obtain many insights into the firm’s past performance and position for the future.

Financial Analysis

• Measures of short-term liquidity

• Measures of long-term credit risk

• Measures of profitability

• Measures for evaluating the current market price of common stock

Measures of short-term liquidity

Current Ratio: A measure of short-term debt-paying ability

Current Assets / Current Liabilities

184,092 / 18,732 = 9.8

The industry standard is 2.1.

GizmoWorks has a strong ability to pay short-term debts!


Quick Ratio: A measure of short-term debt-paying ability

Quick Assets [cash + accounts receivable]

/ Current Liabilities

132,425 / 18,732 = 7.1


GizmoWorks has a strong ability to pay short-term debts!


Receivables turnover rate: Indicates how quickly receivables are collected.

Net Sales / Avg Accounts Receivable

750,000 / 125,000 = 6


GizmoWorks collection experience is similar to its industry.


Day’s to collect accounts receivable:Indicates how many days on average it takes to collect accounts receivable. Also referred to a DSO’s (days sales outstanding)

365 days / Receivable Turnover Rate

365 / 6 = 61

The industry standard is 62.

GizmoWorks collection experience is similar to its industry.


Inventory Turnover Rate:Indicates how quickly inventory sells

COGS / Average Inventory

228,333 / 51,667 = 4.4


GizmoWorks sells its inventory slightly slower than their competitors.


Days to sell the average inventory:Indicates in days how quickly inventory sells.

365 days / Inventory Turnover Rate

365 / 4.4 = 83


It takes GizmoWorks slightly longer than their competitors to sell inventory.


Operating Cycle:Indicates in days how quickly inventory converts to cash.

Days to sell inventory + Days to collect receivables

83 + 61 = 144


GizmoWorks has an operating cycle much like the rest of their industry.

Measures of long-term credit risk

Debt ratio:Percentage of assets financed by creditors; indicates relative size of the equity position.

Total Liabilities / Total Assets

68,732 / 224,094 = 30.7%

The industry standard is 63%.

GizmoWorks has a much stronger equity position than the typical firm in their industry! This puts them in a better position to finance investment opportunities!

Measures of long-term credit risk

Interest coverage ratio:Indicator of a company’s ability to meet its interest payment obligations.

Operating Profit / Annual Interest Expense

96,262 / 4000 = 24 times

The industry average is 4.4 times.

Creditors are often reluctant to lend money to firms if the coverage ratio is less than 4. GizmoWorks has a very strong balance sheet!

Measures of Profitability

Gross profit rate:A measure of the profitability of the company’s products.

Gross Profit / Net Sales

521,667 / 750,000 = 69.9%


GizmoWorks makes over 25% producing and selling its products than their typical competitor!


Operating expense ratio:A measure of management’s ability to control expenses.

Operating Expenses / Net Sales

425,400 / 750,000 = 56.7%


GizmoWorks has relatively high operating expenses. Management should determine whether these expenditures are contributing value to the firm.


Net income as a percentage of sales:An indicator of management’s ability to control costs.

Net Income / Net Sales

55,360 / 750,000 = 7.4%

The industry standard is 3.4%.

GizmoWorks has a significantly higher profit margin than its competitors!


Earnings per share:Net income applicable to each share of common stock

Net Income / Shares Outstanding

100,000 / 1 = 100,000 shares

There is no industry standard – each firm is different.

Investors expect this number to increase consistently over time

Shares outstanding = capital stock / par value

55,360 / 100,000 = .55


Return on assets:A measure of the productivity of assets, regardless of how the assets were financed.

Operating Income / Total Assets

96,267 / 224,092 = 43.0%


GizmoWorks is using their assets very productively!


Return on equity:The rate of return on the stockholders’ equity in the business.

Net Income / Total Equity

55,360 / 155,360 = 35.6%


GizmoWorks is making considerably more profit on invested capital than most firms in this industry.

Stock price = $8.17 Earnings per share = $.55 Dividend per share = $.08

Measures for Evaluating Stock Price

Price-earnings ratio:A measure of investors’ expectations about the company’s future prospects.

Stock Price / Earnings per share

8.17 / .55 = 14.85 times

The industry standard is 12 times.

The market places a greater value on the future earnings prospects of GizmoWorks than most frims in the industry.



Dividend yield:Dividends expressed as a rate of return on the market price of the stock.

Dividends Per Share / Stock Price

.08 / 8.17 = 1%


Many public companies pay no dividends. Dividend policy can be studied in more advanced financial management courses.



Book value per share:The recorded value of net assets underlying each share of common stock.

Stockholders’ Equity / Shares Outstanding

$155,360 / 100,000 shares = $1.55

Firms with a stock price of less than book value is often an indicator of problems with the firm.

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Analysis

Finance 101


Summary

Measures of Short-term Liquidity

• Current ratio = current assets / current liabilities• Quick ratio = quick assets / current liabilites• Receivables turnover rate = net sales / average

accounts receivable• Days to collect receivables = 365 days / accounts

receivable turnover rate• Inventory turnover rate = cost of goods sold / average

inventory• Days to sell inventory = 365 days / inventory turnover

rate• Operating cycle = days to sell inventory + days to

collect receivables

Measures of Long-term Credit Risk

• Debt ratio = total liabilities / total assets• Interest coverage ratio = operating income /

annual interest expense


• Gross profit rate = gross profit / net sales• Operating expense ratio = operating expenses / net

sales• Net income as a % of net sales = net income / net

sales• Earnings per share = net income / shares outstanding• Return on assets = operating income / average total

assets• Return on equity = (net income – preferred dividends)

/ average common stockholders’ equity


• Price-earning ratio = current stock price / earnings per share

• Dividend yield = annual dividend / current stock price

• Book value per share = common stockholders’ equity / shares of common stock outstanding

Max Does Financial Analysis

In a nutshell, here is what I have gathered:

•Very strong balance sheet with low levels of debt.•Much higher profitability measures that most firms in their industry.•Average (at best) working capital management.

This information will form the basis of my recommendations:

They are in an excellent position to

attract capital to grow their business. I

would suggest expanding their

market coverage or perhaps add to their

product line. Because of the strong balance

sheet, they can do this internally, or

take a faster route which is to grow by

acquisition.

A second opportunity for Gizmo is to

explore improving their collection experience or

management of inventory.

Bottom line: this is an excellent firm with

terrific opportunities.

FYI – I have also decided to buy their stock. With Max now on their team I’d be surprised if

the stock price doesn’t double in a couple years. And besides, I don’t see much downside risk

here!

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Analysis

Finance 101


Summary

Documents

FinTut is a computer-based tutorial that students can work through at their own pace. It is used to develop and reinforce a better understanding of financial